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Over the past several years, large U.S. institutions have become an increasingly large portion of hedge fund inflows. In fact, according to a recent Reuter’s article, pension funds, endowments and other large scale American money managers now account for up to three quarters of new money flows into the hedge fund sector. Accordingly, the importance of attracting American assets is growing for European, and even Asian, hedge funds, though significant challenges remain for those trying to enter the U.S. market.

U.S. Regulation Poses Significant Hurdle

One of the major barriers for foreign hedge funds in terms of accessing US investors is the complexity and cost of American regulation. One high-profile hedge fund executive from Europe told Reuters that, “(in terms of regulation) the worst in the U.S.” The requirement to register with both the Securities and Exchange Commission and the Commodity Futures Trading Commission is one such barrier. Many hedge fund managers view the multiple regulators as a hassle, and often face contradictory regulation.

Tax issues also weigh heavily on hedge fund managers looking for U.S. investment. The Foreign Account Tax Compliance Act, or FATCA, will compel all foreign financial institutions to turn over account details to the Internal Revenue Service for American taxpayers with accounts over $50,000. Since tax status is often complex and the penalties for non-compliance are significant, hedge fund views this new regulation as a significant source of regulatory risk.

Competition from U.S. Firms is Fierce as They Defend Their Turf

Foreign hedge funds don’t only have to worry about increasingly vigilant U.S. regulators, but also the fierce competition coming from domestic fund managers within the U.S.  Fund managers looking to crack into the market are having second thoughts about expending resources on what might be an unsuccessful venture.

“The U.S. is the largest market but is very competitive. All our largest competitors are based there. What sense does it make to deploy a tremendous effort with much less success?” Arie Assayag of UBP Alternative Investments, a European Fund Manager, told Reuters.

One of the largest fund managers in Europe, London-based Man Group, has had a similarly negative experience entering the United States market. Despite an intensive effort over several years, American investors still only account for 8 percent of its client base. In response, the company has hired the former head of an American hedge fund, John Rohal, in order to work on improving its attraction of U.S. clients.

This approach seems to be common across the industry and offers an opportunity for American hedge fund professionals looking for an international career. Their inside knowledge of the regulation system and what American clients are seeking can be of significant value to international firms.

And foreign hedge funds do have a competitive advantage, or at least a differentiating factor, when compared to their U.S. peers. Such funds can be viewed as having superior insight in the markets in which they are domiciled, providing potentially superior returns compared to American fund managers investing in the same market. Selling that competitive advantage could offer a significant opportunity for foreign funds in the United States.

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In what is becoming a fairly predictable trend, leading financial regulators are considering tightening regulations to limit global financial risk. However, recently proposed rules coming from the European Union may actually have a destabilizing impact on financial markets, despite the intention of the rules to decrease the risk that any specific institution may become too big to fail. Industry criticism has been swift, with a recent Reuters report suggesting that the changes may create a “regulatory own goal.”

New Rules would require a Depositor Institution to Monitor Hedge Funds

The proposed rule changes include requiring money managers that market funds in the European Union to appoint an independent depository institution. These banks will collect a fee from hedge funds in return for a guarantee of investor money in cases of unauthorized trading. The root driver of the additional regulation was the MF Global situation from 2011, where it is alleged that client funds were used to mitigate losing trades that the firm took on with its own money.

However, it is not clear where depository institutions would be willing to backstop such risk, nor is it clear what the cost would be to hedge funds for this kind of service. Guaranteeing all client investments from imprudent or fraudulent trading active would be a substantial risk for banks, perhaps even tying up large amounts of balance sheet resources to reserve against potential loses. The Alternative Investment Managers Association (AIMA) estimates that the cost to hedge funds may be as high as $6 billion per year.

Rule Change could Increase Market Risk if Hedge Funds move Offshore

Due to the high cost of the depository services suggested by the new regulation, many funds believe that this will make them uncompetitive with money managers located in less stringent jurisdictions. If regulations and compliance costs are not materially equal in all global jurisdictions, it’s reasonable to expect a flow of assets to the least costly places to do business.

Unfortunately for regulators, this often means these funds will be facing even less oversight than they have in their home jurisdictions. The reality of the large scale trades that hedge funds make means that money managers who are taking unacceptably high levels of risk in the under regulated jurisdictions actually puts the entire hedge fund market at risk. If a large trade fails to settle with a fund located in a questionable jurisdiction, another counterparty that may have been following rules in the European Union could also face severe economic consequences. The proposed stringent regulations could actually put European taxpayers in more jeopardy in comparison to less strict rules that would allow more funds to remain competitive in well monitored jurisdictions.

What Does This Mean For Job Seekers?

For the past several years, there has been a flow of some hedge fund jobs from highly regulated markets to markets where money managers have more freedom. Further politicization of hedge fund regulation may force even more regulators to impose unreasonable or irrational rules on the industry, forcing more jobs offshore. Those seeking jobs in the hedge fund industry need to be mindful of potential regulatory changes that may impact funds in their country. Many employees may be facing the choice between relocation or unemployment lines if such regulatory trends continue.

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